Bell hindmoor masters of the universe, slaves of the market (2015)

MASTERS OF THE UNIVERSE,
S L AV E S O F T H E M A R K E T



MASTERS OF THE UNIVERSE,
SLAVES OF THE MARKET
Stephen Bell & Andrew Hindmoor

Cambridge, Massachusetts
London, England
2015


Copyright © 2015 by Stephen Bell and Andrew Hindmoor
All rights reserved
Printed in the United States of America
First printing
Library of Congress Cataloging-in-Publication Data
Bell, Stephen, 1954–
Masters of the universe, slaves of the market / Stephen Bell, Andrew Hindmoor.
pages cm
Includes bibliographical references and index.
ISBN 978- 0- 674-74388-5 (alk. paper)
1. Banks and banking. 2. Financial crises. 3. Global Financial Crisis, 2008–2009.
4. International fi nance. I. Hindmoor, Andrew. II. Title.
HB3725.B45 2015
332.109'0511—dc23
2014028185

In memory of Robert Harold Bell and Fan Austin



Contents

Abbreviations

ix

Introduction 1

1
2
3

Masters of the Universe

4
5
6
7

Bank Performance in Australia and Canada

8
9

Getting It Right: Australia and Canada

15

“Slaves” of Markets and Structures 36
Bank Performance in the United States
and the United Kingdom 74
126

US Banking: Exciting but Not Very Safe 156
The United Kingdom: Banking and Bankruptcy

198

The Survivors: Why Some Banks in the United States
and the United Kingdom Avoided the Carnage 235
259

Bank Reform: Winning Battles but Losing the War?
Conclusion 332

References

343

Acknowledgments 383
Index

385

289

Abbreviations

ABS asset-backed security
ANZ Australia and New Zealand Banking Group
APRA Australian Prudential Regulation Authority
BCBS Basel Committee for Banking Supervision
BMO Bank of Montreal
BNS Bank of Nova Scotia
CBA Commonwealth Bank of Australia
CDO collateralized debt obligation
CDS credit default swap
CEO chief executive officer
CIBC Canadian Imperial Bank of Commerce
CLO collateralized loan obligation
CMBS commercial mortgage-backed security
CRO chief risk officer
ED executive director
FCIC Financial Crisis Inquiry Commission
FDIC Federal Deposit Insurance Corporation
FICC fi xed income, currency, and commodities
FPC Financial Policy Committee
FSA Financial Ser vices Authority
FSOC Financial Stability Oversight Council
HI historical institutionalism
HUD Department of Housing and Urban Development

x

Abbreviations

ICB Independent Commission on Banking
IIF Institute for International Finance
IMF International Monetary Fund
LBG Lloyds Banking Group
MBS mortgage-backed security
NAB National Australia Bank
NED nonexecutive director
OCC Office of the Comptroller of the Currency
OFHO Office of Federal Housing Oversight
OSFI Office of the Superintendent of Financial Institutions
OTC over the counter
OTS Office of Thrift Supervision
PAIRS Probability and Impact Rating System
PRA Prudential Regulatory Authority
RBA Reserve Bank of Australia
RBC Royal Bank of Canada
RBS Royal Bank of Scotland
RMBS residential mortgage-backed security
ROE return on equity
SEC Securities and Exchange Commission
SIV structured investment vehicle
TD Toronto-Dominion
VaR value at risk


Introduction

The banking and financial crisis that peaked in 2008 and that engulfed
many of the major US, UK, and European commercial and investment
banks in the New York and London markets was “arguably the greatest
crisis in the history of fi nancial capitalism” (Turner 2009b, 5). Very few
bankers fully understood the scale and complexity of the new fi nancial
markets they had created, with their vulnerabilities and huge “systemic
risks” and their capacity to infl ict economic carnage on a vast scale. This
book seeks to establish a clear account of what happened during the
crisis, why it happened, and what can be done to prevent another crisis
from occurring.
We argue that the origins of the crisis can be gleaned from answering
an obvious but rarely posed question—Why did the fi nancial and banking
systems in the core economies of the United States and the United Kingdom
implode, while the banking systems in other countries, such as Australia
and Canada, did not? Such comparisons provide a vital clue: banking crises,
or their absence, we argue, are largely driven by the nature of the banking
markets found in each country. We provide a detailed comparative analysis showing how, even within an apparently globalized banking system,
the behavior of individual banks was shaped by nationally specific market
contexts. We fi nd that banking markets with high levels of competition
and low returns from traditional lending are likely to pursue risky forms
of trading activities and are prone to fi nancial crises. In the United States
and the United Kingdom, highly competitive banking markets placed


2

Introduction

bankers under intense pressure to reengineer their balance sheets in the

search for additional profits, largely in highly leveraged mortgage-backed
securities (MBSs) trading. It was the collapse of these markets that triggered
the banking crisis in 2007. Such pressures were strong in the United States
and the United Kingdom, but weak in the Australian and Canadian markets. National market conditions in banking thus emerge as the key explanation of the origins of the crisis.
We also show that structural forces embodied in so-called systemic risk
within fi nancial markets were central in driving the scale of the banking
and credit crisis. Systemic risk was manifested in the high leverage or debt
relationships between major banks and wholesale funding markets in the
United States and the United Kingdom. When the value of MBSs collapsed,
bankers and credit markets became uncertain about which banks were
facing what losses. The result was a market panic that saw credit markets
freeze. This was the proximate cause of the scale of the crisis.
Unlike during the 1930s, the fi nancial crisis that began in 2007 and
peaked in 2008 did not stem from a collapse in the real economy. Nor was
it on the whole an old-fashioned banking crisis caused by poor lending decisions to corporate borrowers with inferior credit standards. True, some
banks, such as HBOS in the United Kingdom and Wachovia in the United
States, were compromised by the legacy of poor corporate and property
lending decisions, but for most banks, as we show in Chapter 3, loan default rates were relatively low. For example, Lloyds Bank and Barclays Bank
in the United Kingdom had loan impairment rates of only 2.5% and 2.7%,
respectively, in 2007, while in the United States, Bank of America had just
0.6% of gross loans recorded as impaired in 2007, while Citigroup and JP
Morgan Chase had impaired loans at just 0.25% and 0.15%, respectively.*
The origins of the financial crisis can instead be traced back to losses in
subprime MBS markets in the United States. However, the subsequent scale
and severity of the crisis stemmed not simply from these losses, which were,
when measured against the size of the overall financial system, relatively
small, but from a more general fall in the value of the assets held on bank
balance sheets and especially by the freezing of wholesale funding mar* Unless otherwise attributed, data relating to bank balance sheets in this and subsequent chapters is drawn from the OSIRIS database.

Introduction

3

kets on which banks relied. Much of this was driven by market overreaction and panic in response to the initial subprime and MBS losses and by
uncertainty about which banks were sitting on what losses as the crisis unfolded. It was the fragile nature of the fi nancial structures that had been
created and the systemic risk thus generated that was the core problem.
Most accounts of the crisis offer either exposés of greedy, reckless bankers
and financiers, or long lists of factors that contributed to the crisis: from
low interest rates that fueled housing and fi nancial asset bubbles, to weak
financial regulation, to the collapse of the US subprime real estate market,
to the subsequent unraveling of the complex financial instruments built
on subprime mortgages. The former accounts are usually written by journalists or bank insiders and offer detailed descriptions of what happened
inside banks but often fail to adequately place banks in wider contexts of
influence (W. Cohan 2009, 2011; Sorkin 2009). The latter accounts are usually offered by economists, but the “list” approach makes it hard to tell what
really matters or how contributing factors fit together (Davies 2010; Stiglitz 2010; Blinder 2013).
This book offers a different approach, one that allows us to isolate key
drivers of the origins and scale of the crisis from the long list of causal factors produced in many accounts. It is true that the factors just noted were
a part of the story. But these were not the primary factors that actually drove
banks and the behavior of bankers. Regulation, for example, was focused
mainly on capital levels in individual banks and lacked a perspective on the
system as a whole. Nor did regulation seriously probe or question the rise
of trader banks, the growth of the so-called shadow banking system, or
the buildup of trading or leverage in the core markets. Indeed, in some ways,
regulation encouraged such trends. Regulation, then, was permissive. It
interacted with markets, but it did not fundamentally drive bankers in the
direction they took, especially in pursuing trading and massive leverage
structures. Indeed, in the United States and the United Kingdom, powerful bankers were highly influential in obtaining the regulation they required. Our analysis thus distinguishes between more fundamental causal
factors such as market structure and those that were merely permissive.
Our institutional and structural analysis of the crisis points primarily to

the impacts of liberalization and “financialization,” especially intense market
competition; new, attractive trading opportunities; and the buildup of


4

Introduction

system complexity and risk in the core markets. In Australia and Canada
we also show how the absence or diminished nature of such factors produced quite different outcomes.
We thus argue that the economic and financial crisis was essentially a
banking crisis driven by bankers interacting with institutional and wider
structural contexts that strongly shaped behavior and outcomes. Starting
in the 1970s, bankers and state leaders in the heartlands of global fi nance
in the United States and the United Kingdom presided over the liberalization of financial markets. This was a major institutional change that radically expanded the domain of markets, market forces, and competition in
contemporary capitalism and in finance. Liberalization was partly a reaction to the strong fi nancial regulation of the postwar decades: a period in
which banking and finance were restrained by the capital controls and fixed
exchange rates of the postwar Bretton Woods international fi nancial architecture and by domestic interest rate and credit regulations. These regulations were put in place as a response to the fi nancial and banking calamities of the 1930s and as part of postwar efforts to stabilize the financial
system. Financial liberalization from the 1970s lifted these shackles and
resulted in what is now often called financialization: a structural change
in capitalism marked by the huge and growing scale of the fi nancial sector.
The incentives and pressures embodied in banking markets are central
to our story. In the crisis-hit countries, market incentives built around remuneration systems offered huge rewards for those willing to take risks in
the growing financial markets. Competitive market pressures and the fear
and market penalties of being left behind by competitors drove many banks
to take extraordinary risks, especially with the new fi nancial instruments
associated with the securitization bonanza that took off in the first decade
of the twenty-first century (hereafter referred to as the 2000s). This saw
formerly illiquid assets such as mortgages and other forms of debt repackaged into complex tradable securities such as collateralized debt obligations
(CDOs) or collateralized loan obligations (CLOs). These were assembled

and traded on an industrial scale, and, as noted, their collapsing values in
2007 and 2008 sparked the crisis. Such trading was pumped up by a huge
increase in bank debt or leverage, the latter defined as bank debt relative
to capital. To rapidly expand their trading and asset portfolios, banks borrowed more and more money, which meant a huge increase in exposure to


Introduction

5

short-term wholesale funding markets. The growth of financial trading and
leverage within interconnected banking and fi nancial markets amplified
systemic risk, a structural feature of financial markets that made the system
more fragile and prone to chain reaction effects, panics, and fi nancial collapse (Haldane and May 2011).
Bankers, while authoritative within their own proximate institutions (and
in relation to the state), were in fact constrained, and in many cases they
appeared as almost “enslaved” by these wider institutional and structural
pressures. In the United States and the United Kingdom, liberalization had
freed bankers and fi nanciers from earlier forms of regulation, but it had
subsequently constrained them in highly competitive markets that generated strong pressures to engage in high-risk banking practices that increased
systemic risk and set the stage for the collapse of the entire system.
Nevertheless, not all bankers, even in the United States and the United
Kingdom, succumbed to these pressures. As we show in later chapters, the
ideas held by senior bankers were also central to how they read the situation and how they acted. Those who were sanguine about market developments and who truly believed in the financial boom were the ones who
became “enslaved” by it. They did not much question the market and institutional pressures they confronted and instead joined the herd and rode
the boom.
Important here too was the fact that liberalization did not result in the
retreat of the state from financial markets. Deregulation created opportunities for banks to reengineer their balance sheets, but governments continued to support the growth of the fi nancial sector through depositprotection schemes and explicit guarantees in the United States and implicit
guarantees in the United Kingdom that banks that were deemed “too big
to fail” would, if necessary, be bailed out in a crisis. This form of state support constituted a type of moral hazard that encouraged further risk taking.

Moreover, other fi nancial regulations, especially the design of capital
controls, further encouraged the growth of the shadow banking sector composed of nonbank financial entities and the securitization of financial assets. Our key argument, then, is that bankers (and supportive state elites)
in the core, interlinked Wall Street and London fi nancial markets created
but were then overwhelmed by the market institutions and fi nancial structures they had built.


6

Introduction

We use the methods of political science to study the behavior of bankers
in these institutional and structural contexts. We draw on institutional
theory, especially historical institutionalism, to help us understand how
bankers shaped and were shaped by the banks and wider institutions and
structures in which they operated. Agents and the contexts in which they
operate are mutually shaping. This key insight will help us explain banking
behavior and outcomes. Studying such “agency-structure” interaction has
long been a staple of political science analysis. In this perspective, institutions, such as banks, are best seen as mediating the relations between agents
and wider contexts. The ideas held by agents are also an important mediator, shaping how agents perceive the world and operate within it. Furthermore, as Streeck (2009) argues, we need to locate institutional analysis, particularly in political economy, within an account of broader systemic or
structural transformations, especially in relation to major transformations
in capitalism in recent decades, such as financialization. This is a more realistic and encompassing approach than the current mainstay of comparative political economy, the varieties of capitalism approach (Hall and Soskice 2001), which tries to explain the behavior of firms as rational efficiency
seekers shaped by relatively narrow sets of institutional parameters.
Most strands of institutional theory argue that institutions heavily shape
and constrain agents. Yet senior bankers were (and remain) authoritative
within their own institutions, especially in the core markets of the United
States and the United Kingdom. In the 1990s and 2000s these Masters of
the Universe— a phrase popu lar ized by Tom Wolfe’s account of a Wall
Street tycoon in The Bonfire of the Vanities—reshaped their institutions and
revolutionized banking and fi nance. During this period, a new kind of
“trader bank” (Erturk and Solari 2007) emerged, characterized less by traditional lending to businesses and house buyers, and more by securitization and large-scale fi nancial trading supported by highly leveraged

wholesale borrowing and massive balance sheet expansion. Such activities
explain why between 2004 and 2007 the balance sheets of the world’s ten
largest banks more than doubled in size, while the balance sheets of banks
in the United Kingdom grew to five times GDP (Acharya, Cooley, et al.
2009, 286). As we demonstrate through a detailed analysis of bank balance
sheets in Chapter 3, however, the largest UK and US banks reengineered
their balance sheets in different ways and to differing degrees. In the United


Introduction

7

Kingdom, the Royal Bank of Scotland (RBS) and Barclays massively expanded their investment bank operations. HBOS largely avoided fi nancial
trading but became overcommitted in mortgage and commercial property
lending. JP Morgan Chase entered but then wound back its exposure to
the securitization market. Citigroup, Merrill Lynch, Bear Stearns, and
Lehman Brothers demonstrated no such reticence. Between January 2006
and August 2007, for example, Citigroup issued $18 billion in CDOs, which,
rather than being sold to third-party investors, were retained on the bank’s
own balance sheet (FCIC 2011, 196). By December 2007 Citigroup had accumulated $37 billion of “sub-prime related direct exposures,” $43 billion
of “highly leveraged loans and financing commitments,” $22 billion of Alt-A
mortgage securities (Citigroup 2008, 10), and $114 billion in off–balance
sheet guarantees. While the individual details of bank balance sheets differed, the largest banks in the United States and the United Kingdom appeared collectively to have fashioned new kinds of immensely profitable
financial products, mastered risk, and launched a “platinum age” for the
global economy.
Bankers and cooperative state elites, especially in the United States and
the United Kingdom, built this new liberalized fi nancial system. The majority of bankers and financiers were driven by sanguine beliefs about the
safety of the new markets and products they had created and by the huge
material rewards these markets offered. Liberalization and fi nancialization

also had important political spillovers. They helped create a power structure that bewitched most political and regulatory leaders, who saw financial sector growth as a valuable source of innovation, taxes, jobs, and national prestige. In turn, states provided subsidies that cheapened credit for
big banks, as well as low official interest rates and permissive forms of financial regulation.
Then came the crash. Our account of how this unfolded is contained in
Chapters 1 and 2, which emphasize the way in which agents became trapped
within the financial structures they had created. The turmoil began with
the collapse of the real estate bubble in the United States and the associated losses in the subprime mortgage securitization markets, starting in
2007. These collapsing markets then produced losses on the balance sheets
of exposed banks. Importantly, these declared losses were not huge, yet they
were sufficient to trigger the crisis. This is because the banking system that


8

Introduction

had evolved during the fi nancial boom was highly vulnerable to systemic
risk fueled by chain reactions and market panics. MBS trading turned out
to be risky, partly due to the complexity and opacity of the securities that
were being traded. The myriad and largely opaque debt and trading interconnections among banks worldwide made it very hard to calculate counterparty risk. Exactly who was holding what and who was going to lose how
much as a result of falling asset prices became impossible to determine.
Sentiments in this context were important. As the crisis gathered, fear and
eventually panic engulfed the system. Banks and other fi nancial institutions stopped lending to each other, and interbank credit evaporated. This
soon led to a general liquidity crisis that destroyed banks and damaged
whole economies. Leverage, opacity, complex interdependencies between
financial institutions, and dependence upon short-term wholesale funding
were the sources of systemic risk that were the proximate causes of the implosion of Northern Rock, Bear Stearns, Lehman Brothers, HBOS, and
RBS.
Bankers and fi nanciers had created this fragile asset and debt structure
in the decades prior to the crisis. And in a classic two-way agency-structure
interaction, it was the structure of systemic risk that would eventually be

their undoing. Our Masters of the Universe had unwittingly sealed their
own fate. Prior to the crisis, bankers appeared to be in complete control.
Yet they were in fact operating in a highly fragile structure they had created. Liberalization empowered the Masters of the Universe, but it also
trapped them within institutions and structures they did not fully understand and could not control. Bankers were overwhelmed and were revealed
as almost slaves of the markets they had helped create. The story here is
also analogous to the fate of the brilliant creator of the Frankenstein monster that eventually turns on its master.
We know that the nature of banking markets and the intensity of competition among the largest banks were important causes of the crisis because different types of market context shaped different forms of banking
behavior across countries. The 2007–2008 meltdown is often described as
a “global” financial crisis. Yet outcomes varied markedly across countries,
something that is often overlooked within previous accounts of the crisis
(although see J. Friedman 2009, 152–155). Banks in Australia and Canada,
for example, largely avoided trading the kinds of securities based on US


Introduction

9

subprime mortgages that sparked the crisis. Much the same applies to banks
in Japan, Israel, France, and Spain (Howarth 2012; Royo 2012). The main
reason why so many bankers behaved differently in these countries is that
the banks were operating in different kinds of markets, especially in relation to the level of competitive pressure and the nature of profit opportunities. Banks in Canada and Australia, on which we focus in Chapters 4
and 8, could make high profits through traditional lending practices and
did not confront the same pressures to reinvent themselves as trader banks.
They thus avoided the fate of most of the bankers in the core US and UK
markets.
While we emphasize the impact of institutions and structures on agents,
our account is not deterministic. As noted above, although institutions
and structures exerted strong pressures, what also stands out is a small but
nevertheless significant level of within-country banking variation in the

United States and the United Kingdom. The particular character of agents
and their ideas, as well as corporate cultures, thus matters. Different agents
and bank cultures can interpret the same context differently and potentially act with at least some degree of discretion. Despite the fi ndings of
behavioral fi nance theory, which we detail in Chapter 1, not all bankers in
the core markets became irrationally exuberant or rushed to follow the
herd. The particular and variable patterns of discretion and insight forged
by agents, even in similar institutional contexts, are thus an important part
of our story, reflecting the variability of agents’ ideas and discrete microinstitutional capacities. As we show in Chapter 7, a number of banks in
the core markets largely avoided the meltdown. Banks such as HSBC and
Lloyds TSB (prior to its takeover of HBOS) in the United Kingdom
and JP Morgan, Wells Fargo, and Goldman Sachs in the United States
avoided the worst of the carnage. They were not swayed by the euphoria
of their rivals and managed either to resist intense market pressures to copy
the apparently successful strategies of their immediate rivals, or, in the case
of Goldman Sachs, having accumulated significant exposures, managed to
reverse their positions. We show how and why they did this, underlining the
fact that sometimes some agents can resist or sidestep wider pressures.
There are two other features of this book. First, having set out the institutional and structural pressures that shaped bankers in broad terms in
Chapters 1 and 2, we then focus on bankers in the United States and the


10

Introduction

United Kingdom at a finer level of detail. In Chapter 3, we get inside the
major banks in these countries through a meticulous analysis of their balance sheets, specifying their trading and leverage exposures. Here, we draw
extensively upon annual reports and fi nancial statements as well as standardized data on company performance. In Chapter 5 on the United States
and in Chapter 6 on the United Kingdom, we also get inside these banks
through interviews and other accounts of how bankers thought and acted

at the micro level. While we emphasize institutional and structural pressures and constraints on bankers, it is also necessary to explore how bankers
themselves interpreted, shaped, and responded to such pressures. Only by
reconstructing such an account of agency and the contexts in which bankers
operated can we explain why bankers behaved as they did. This approach
will allow us to understand why bankers at banks such as Bear Stearns, Citigroup, or RBS so badly misread their positions and eventually succumbed
to systemic pressures and collapse. It will also allow us to understand why
bankers at JP Morgan or Wells Fargo read their situation differently and
avoided the worst trading excesses and avoided a meltdown. This approach
will also help us understand why Canadian and Australian bankers did not
reengineer their balance sheets and become trader banks despite multiple
entreaties to do so. In aiming to reconstruct the mind-set and strategy of
bankers and show how this shaped and was in turn shaped by the contexts
in which they operated, we utilize insider accounts of what bankers did and
how they thought. We use testimony on crisis inquiries in the United States
and the United Kingdom and the transcripts of interviews we conducted
in 2012 and 2013 with bankers, regulators, and other informed observers.
Second, our book directly links its causal analysis of the crisis to a diagnosis of contemporary reform measures. The two key drivers of the crisis
were risky securities trading in the context of massive leverage and mounting
systemic risk. Trading and systemic risk thus need to be addressed through
major reforms. As we argue, however, this is not what is happening. Bank
lobbying and reticent governments have instead produced relatively small
increases in bank capital and have attempted to shield commercial banking
from the excesses of trader banking. Neither reform goes far enough or
squarely addresses the root causes of the crisis. Moreover, governments in
the United States and the United Kingdom still appear to favor large, complex fi nancial sectors. They also persist in believing that highly competi-


Introduction

11

tive banking markets are inherently valuable, without recognizing that competitive market pressures were one of the structural roots of the crisis. The
deeper problem limiting reform is that bankers and fi nancial interests remain powerful in the United States and the United Kingdom and in wider
settings. This is not just due to their famed lobbying capacity. Their power
also derives from the structures that liberalization and financialization have
created. The centrality of fi nance in the core economies has produced a
high degree of state dependence on finance, particularly as a source of jobs,
tax revenue, and credit, as well as campaign contributions. In the United
Kingdom, this has been distilled as the “British Dilemma” by Chancellor
George Osborne (2010): the need to “preserve the stability and prosperity
of the nation’s entire economy” while also protecting London’s status as a
“global financial centre that generates hundreds of thousands of jobs.” State
elites on both sides of the Atlantic still believe in “big fi nance.” We argue
that despite the crisis and attempts at reform since, the underlying nexus
between fi nance and the state still persists, limiting more fundamental
reform.

The Chapters
In Chapter 1 we unpack the theoretical tools we will use to explain the
behavior of bankers in the four countries we study—the United States, the
United Kingdom, Canada, and Australia. At the level of agency, we show
how findings from behavioral fi nance research help us understand behavioral pathologies such as market overshooting and herding behavior among
bankers. However, we need to place agents in wider shaping contexts. We
employ a historical institutionalist approach because we believe this offers
the best way to understand the mutually shaping interactions between our
key agents (bankers) and the institutional and wider structural contexts in
which they operated. We focus on bankers and emphasize how the contexts in which they operated partly shaped their beliefs, preferences, and
behavior, their institutional discretion, and the resources and opportunities available to them.
In Chapter 2 we show in more detail how bankers in the fi nancial heartlands of the United States and the United Kingdom revolutionized banking
in the 1990s and 2000s and how this resulted in the massive growth of bank

12

Introduction

balance sheets, securitization, financial trading, leverage, and wholesale borrowing. We explain the complexities of the new fi nancial engineering and
innovation that led to an explosion in fi nancial trading through processes
such as securitization and the creation of financial instruments and derivatives such as CDOs. We also trace how this process was funded and how
banks radically expanded their balance sheets by taking on massive leverage.
In the second part of the chapter we then describe how the fi nancial crisis
unfolded in 2007–2008—how the downturn in the US subprime market
sparked a far larger crisis in the banking system: fi rstly, through balance sheet losses from collapsing prices in MBSs and other trading assets and, secondly, via the systemic risk created through the extension
of leverage and wholesale funding in increasingly opaque, complex, and
fragile markets.
In Chapters 3 and 4 we analyze the banks in the four countries we study.
We provide a detailed analysis of bank balance sheets that shows how the
largest banks in the United Kingdom and the United States (Chapter 3)
and Australia and Canada (Chapter 4) behaved in the years prior to the
crisis. These chapters describe what the major banks in each of these countries actually did and show how variable bank behavior actually was, both
across countries and within them.
In Chapters 5 and 6 we examine how bankers and regulators in, respectively, the United States and the United Kingdom thought and behaved in
the years prior to the financial crisis. Institutional incentives and increased
competition encouraged many banks to extend their leverage, trading, and
dependence upon wholesale funding, leading to the growth of an extremely
fragile banking system characterized by the presence of huge systemic risks.
Did bankers and regulators recognize these risks? We argue that, in most
cases, they did not. The prevailing ideas held by most bankers did not question the institutional pressures and incentives that drove them on. Bank
executives believed that their internal risk management technologies allowed them to carefully calibrate risks; that securitization had led to a dispersal of risk; that the use of derivatives such as credit default swaps (CDSs)
had allowed them to effectively insure risks; and that continued economic

growth would create further profit opportunities. Executives were also reassured by the sanguine risk assessments of credit rating agencies, boards
of directors, regulators, and politicians, who expressed few concerns about


Introduction

13

whether the financial boom was sustainable and, in many cases, actively
encouraged risk taking. We use interview material and documentary evidence to show how most bankers understood the financial world prior to
the crisis. We show how they reconstructed their banks and shaped wider
institutional arrangements, such as regulation and risk management, in pursuit of their strategies. In this way, these two chapters complement and extend the detailed balance sheet analysis of individual bank performance in
Chapters 3 and 4 and the broader and more general argument about institutional change and the accumulation of systemic risk in Chapters 1 and 2.
In Chapter 7 we explain how some of the more prudent UK and US banks
mentioned earlier managed to largely avoid the crisis. We explore why these
banks resisted pressures to become trader banks and why others that did,
such as Goldman Sachs, outwitted the market and reversed or offset their
exposures prior to the crisis. Given the pressures on the banks in these
markets, this is a story about agency and about swimming against the tide.
It is about the different ways in which executives in these banks saw and
understood the world prior to the crisis and about the different ways in
which these banks operated, often exploiting particular market niches and
capacities. Despite institutional and structural pressures, these more prudent banks show that agents can sometimes confront wider forces and carve
out distinctive strategies. One of the great unanswered questions, however,
is how long some of these banks could have held out if the boom had continued for several more years.
In Chapter 8 we show how and why the major Canadian and Australian
banks similarly avoided joining the herd. We argue that government regulation of the market, particularly of capital and leverage, was stronger in
these countries and that this partly explains the conservatism of these banks.
We also argue that in both countries earlier banking crises had a chastening
effect on behavior. Bank behavior was, however, also strongly shaped by

market forces. In both countries competitive pressures were less intense,
and high profits could also be made from traditional business and mortgage lending within buoyant economies. This reduced the incentive banks
had to reengineer their balance sheets and empowered agents within the
banks who perceived the risks inherent in adopting new trading strategies.
Finally, Chapter 9 addresses questions about bank reform. It argues that
this needs to focus on market pressures that drove risky trading and the


14

Introduction

excessive buildup of leverage within banking systems. Current reforms to
boost the capital base of banks and to try to shield commercial banks from
risky trading are a start but do not go far enough. Bolder moves are required to reduce the market pressures that drive risky trading and leverage.
Canada and Australia show what a model of sound banking and finance
looks like, so there are lessons here about how to build more resilient
banking systems, especially in terms of market structures that incentivize
more conservative and stable forms of banking. The Conclusion provides
an overview of our key arguments.